Commercial Loans - Calculating Debt Coverage Ratio

When dealing with commercial loans, a very important ratio in lending is the DCR, or debt coverage ratio. This is the ratio that gives a snapshot of the financial health of a particular property.

In simple terms, the DCR, or debt coverage ratio, tells us how much money the property is making or losing. It is based on a scale of one, with a debt coverage ratio larger than one meaning the property is cash flow positive, and a debt coverage ratio less than one meaning that the property is cash flow negative.

A simple way to remember is that the debt coverage ratio, loosely, is telling you how much income, per dollar of expense, your property is making. So a DCR of 1.25 loosely means that the property is bringing in $1.25 for every $1.00 in expenses.

The first step in calculating the DCR of a commercial property is to find the net operating income, or NOI, or net operating income. In order to calculate the Net operating income, you will first need to find the total operating expenses. Operating expenses are just that, all of the expenses and allowances associated with your commercial property. Do not include your mortgage expenses in this figure, but do include any replacement reserve.

Once your operating expenses are calculated, you need to find your effective gross income. This is all of the income derived from the property minus your vacancy factor. Subtract your operating expenses from your effective gross income and you are left with your net operating income, or NOI.

When dealing with commercial loans, these are all good figures to know. There are a number of calculations that can be done with these numbers, but the one we will focus on is the DCR, or debt coverage ratio.

Now, you have your NOI, which is your net operating income. This is all of your income after expenses, but not mortgage expense. Now we are going to bring in the mortgage expense to figure the debt coverage ratio. The formula to calculate the DCR is:

DCR = NOI/TDS, where DCR is debt coverage ratio, NOI is net operating income, and TDS is total debt service (your mortgage payment). These numbers should all be annual figures.

So if your NOI is $120,000 and your debt service was $10,000 per month, or $120,000 annually, your DCR would be 1. A larger number would mean that your NOI exceeded your TDS (a good thing if looking for a commercial loan). A smaller number would mean that your property is unable to debt service.

A good way to use this formula is to calculate it for the DCR the bank requires. To do this, change the formula to read:

TDS = NOI/DCR

This allows you to take two known figures, your NOI and the bank required DCR, and figure what the largest loan you could obtain is. For example, if your NOI is $100,000, and the required DCR is 1.25, you would have a maximum allowable debt service of $80,000. If you know the rate will be 6%, amortized over 30 years, you can use a simple amortization calculator to calculate your maximum loan amount. In this case it, it would be $1,111,945.

Check back in, we will be looking at more related terms and information regarding commercial loans.